Macquarie's Moore gambles and wins

‘Just because your asset price is less than the value’, Macquarie Group’s Chief Financial Officer Greg Ward was reported by The Wall Street Journal to have said late last week, ‘you don’t mark to market’. Ward was toeing the company line on Macquarie’s determination to carry significant investments in Macquarie Airports and Macquarie Infrastructure Group on its balance sheet at well above current market value.
Imagine how clerks in Macquarie’s former margin lending business (now on the books of Bendigo & Adelaide Bank) might have reacted to the same argument when asking clients for margin calls due to plummeting stock prices. We suspect it wouldn’t have washed. Macquarie’s margin clerks would surely have taken the hard line on keeping loans in check based on market prices rather than the borrower’s own estimate of value. It’s embarrassing and somewhat unnerving that Macquarie holds itself to a lower standard.

   

Once renowned for its conservatism under previous chief Allan Moss, Macquarie Group’s accounting is starting to look more aggressive than Kevin Rudd on a flight from Port Moresby, and our level of discomfort is rising. The suspension of disbelief relating to investment values helped Macquarie to an $871m reported profit for the year to 31 March.
The group’s holdings in its own listed managed funds are carried at more than $1bn above their current market values and most analysts are, rightfully, calling attention to this. But we’re also concerned about the true worth of more than $1.2bn of unlisted Macquarie-managed funds and almost $3.2bn of other unlisted investments. We believe writedowns on these are likely. Some take Macquarie’s current expectation of fewer writedowns next year at face value but if conditions remain subdued, or deteriorate further, the auditors may not give management a choice.

Bad debts soar

Bad debts are soaring across the group’s various lending operations, which were previously known for their conservatism and hard line on collections. Some segments of Macquarie’s $25.3bn in total loan assets are experiencing nasty impairments. These totalled some 12.8% of the group’s $1.5bn of commodity loans at 31 March, and 12.1% of $1.4bn in real estate loans.
Comparisons with last year are difficult given changes in Macquarie’s loan book (with sales of its margin lending book and Italian mortgages business) but, overall, impairment provisions covered a significant 2.6% of the group’s $25.3bn of total loan assets at 31 March.
This could be a sign that Macquarie has taken its medicine early on any bad loans and that impairment levels will be lower in coming years. It could also be indicative of imprudent lending in the boom years, with more fallout to follow. It’s difficult to tell without drilling right down to specific loans but given management’s newly-found accounting aggressiveness in other areas, we wouldn’t like to bank on the former scenario.

Reported results

This was a low quality profit result. While the notion that Macquarie has remained profitable through this tumultuous period is appealing (given its international peers plunged into the red), more conservative accounting would have seen it report a loss, or go very close to it.
As it is, the result was aided by paying a level of tax so low it wouldn’t have been out of place in a small European principality (less than 2%). Profit was also boosted by write-ups on complex debt transactions yet, even with those fillips, the group still fell short of its previous earnings guidance of $900m. Such a result contrasts with Macquarie’s history of over-delivering on its promises.
The final dividend was cut from last year’s record $2.00 per share to just 40 cents, 60% franked. Our reading is that Macquarie, like all banks, is mindful of its capital requirements and we commend management for avoiding the charade of an underwritten DRP.

Capital raising opportunity

MD Nicholas Moore kept a great poker face through the early part of this year, telling anyone who’d listen that Macquarie’s ‘capital position remains strong’. In fact, an official ASX announcement on 26 February used those exact words. Our analysis on 13 Mar 09 (Hold – $18.88), titled Macquarie: More capital, Guv?, indicated that things weren’t as comfortable as they might appear on the surface.
The doubling of Macquarie’s share price from its low of $15 in early March created a double opportunity. The first was for Moore, allowing him to announce a capital raising with the group’s annual results. The preceding share price surge signals that Moore played his cards very close to his chest on this move.

Table 1: Share Purchase Plan details

Potential amounts	$2,500, $5,000, $10,000 or $15,000
Price	$26.60 (or lower of 5-day average price up to 29 May)
Entitled to dividend?	No
Possible scale-back?	Yes (and likely)
Record date	30 April
Applications posted	11 May
Closing date	29 May
Allotment date	5 June

The second opportunity lies in a profitable arbitrage play. Macquarie placed 20m new shares with institutions at $27 apiece, with a follow-on retail offer of up to $15,000 of shares, subject to a discretionary scale-back. The price will be the lower of $26.60 and a 5% discount to the weighted share price over the 5 days leading up to 29 May (any shares issued will not be entitled to the 40 cent final dividend). Table 1 shows the details.
This provides shareholders with the opportunity to sell some of their shares (or all, depending on the size of their holding) at the current price and buy them back through the offer. Indeed, we’ve undertaken this exact operation in our Growth Portfolio (see Growth Portfolio banks free profits).

On the plus side

Having highlighted our concerns, let’s consider some of the positives. The first is that management is clearly not asleep at the wheel. Apart from the cunningly executed capital raising, full advantage has been taken of the federal government’s support through deposit and wholesale funding guarantees. This has allowed Macquarie to strengthen its balance sheet.
Retail deposits surged by 103% to $13.4bn over the year to 31 March, with total deposits comprising 25% of funding requirements, up from 18%. This reduces Macquarie’s reliance on sometimes finnicky short term money markets. And the maturity profile of Macquarie’s debt increased to an average of 3.7 years as at 31 March, from 3.5 years at the same point last year, thanks to government-guaranteed bond issues. So the funding (or liability) side of the balance sheet looks sturdier than ever.

Growth plans

On the revenue-generation front, acquisitions are top of mind. Earlier this year the downstream gas trading business of Constellation Energy was purchased in the US. Combined with the existing Macquarie Cook Energy operations, this group is now a significant player in its markets and a meaningful business for Macquarie shareholders.
Moore wants to see Macquarie add to its strategic position in most businesses while competitors are struggling and has flagged potential opportunities in international stockbroking, in particular. Such a move seems to fit with the group’s history of astute counter-cyclical acquisitions and we’d likely support it (pending any details).

Price surprise

Following what we consider a weak result and a capital raising at $27, the strong share price performance is noteworthy. The recent bout of optimism in markets and the rash of significant corporate transactions (such as Kirin’s offer for Lion Nathan and Canadian Group Viterra’s proposal to ABB Grain) bode well for Macquarie. If these trends continue, the group will be a major beneficiary.

Table 2: Financial data

Year to 31 March	2007A	2008A	2009A	2010E
Income ($m)	7,181	8,248	5,526	5,600
NPAT ($m)	1,463	1,803	871	800
EPS (c)	5.92	6.71	3.10	2.50
PER (x)	6.0	5.3	11.5	14.2
DPS (c)	3.15	3.45	1.85	1.25
Franking (%)	100	100	76	60
Yield (%)	8.9	9.7	5.2	3.5

Such potential is balanced against the risk of another downturn. A confidence-sapping rout from here would hurt volumes in key businesses, dampening the outlook for operating income (which is almost surely running below last year’s levels at the moment). And Macquarie’s auditors cannot forever stand by its above-market valuations of listed funds. If the market prices of Macquarie Airports and Macquarie Infrastructure Group remain below Macquarie’s carrying value at 30 September, we imagine Moore will be placed in a metaphorical headlock by auditors and forced to face reality.
We’re watching management’s moves with interest. This latest capital raising is a positive, showing that Moore didn’t fall for his own spin regarding the group being sufficiently capitalised. And we’ll be keen to review any acquisitions he undertakes in the coming months. The share price is up a hefty 26% since 31 Mar 09 (Hold – $27.07) and our view remains HOLD.

Income securities

In June last year we recommended subscribing to the float of Macquarie Convertible Preference Securities (MQCPA). While the market has fallen by more than 30% since the float, these securities have recently been trading at face value – leaving their investors with an attractive annual yield of 11.1% and no capital losses. That’s a terrific result in the circumstances.
These securities were floated back when Lehman Brothers was still a going concern and the oil price was closer to US$150 than US$50. With most developed economies now in recession, the global banking system is arguably under more stress today than it was then.
Offsetting those negatives are a 5-year fixed rate of 11.1% (with just over four years left to run) and the reassurance provided by this latest capital raising. In all, we’ve increased both the fundamental and share price risk ratings on these securities by half a notch (both to 2.5 out of 5) but we remain comfortable with owners continuing to HOLD.